As a financial planner who's helped hundreds of individuals and couples transition to retirement, I’m always looking for ways to help people maximize their retirement savings and improve their overall quality of life. One strategy that many people default to is the well-known 4% rule. While it's a simple and effective starting point for determining how much you can safely spend each year in retirement, it's important to recognize that it has its limitations.
In this post, I'll break down four critical flaws in the 4% rule and offer an alternative solution that I believe provides more flexibility and personalization for your retirement spending.
Before diving into the critiques, let’s quickly review what the 4% rule is. Developed by financial planner William Bengen, the 4% rule says that you can safely withdraw 4% of your retirement portfolio in your first year of retirement and then adjust that amount for inflation each year. This rule is based on a 30-year time horizon and assumes that your portfolio is invested in a traditional 50/50 mix of stocks and bonds (50% U.S. large-cap stocks and 50% U.S. intermediate-term bonds).
On the surface, it seems like a safe, straightforward plan. However, the rule has some significant limitations that you should consider.
The 4% rule was designed to withstand even the worst market conditions in history, but that also means it might leave retirees underspending. In fact, when you look at historical data, there are many periods where retirees could have safely withdrawn 5-6% per year without running out of money.
Research from financial planner Michael Kitces shows that in most cases, retirees end up with more money than they started with—sometimes significantly more. In fact, Kitces found that the median outcome of following the 4% rule leaves retirees with nearly three times their original balance after 30 years! While this may sound like a good problem to have, it’s not ideal if your goal is to enjoy the fruits of your labor during retirement, not simply to leave behind a large inheritance.
The 4% rule assumes that all of your retirement savings are in pre-tax accounts, like 401(k)s or traditional IRAs. However, most people have some combination of pre-tax, Roth, and taxable brokerage accounts/savings to rely on for retirement income. This mix of account types can significantly affect your taxes (in a good way if you plan properly), and the 4% rule doesn’t take that into account.
For example, withdrawals from pre-tax accounts are taxed as ordinary income, while selling investments in taxable brokerage accounts may only trigger lower capital gains rates—or not at all, depending on your income and cost basis on the investments. Roth accounts, on the other hand, allow for tax-free withdrawals.
By not factoring in the tax implications of withdrawals from different account types, the 4% rule may lead you to believe you can spend more than you actually can, after taxes are accounted for.
One of the biggest oversights of the 4% rule is that it assumes you’ll spend the same amount of money each year in retirement. In reality, spending tends to follow a different pattern.
Studies show many retirees spend more in the early years of retirement, often referred to as the “go-go years,” when they are more active and traveling. As they settle into retirement and become less mobile, spending generally slows down during the “slow-go years,” before rising again later on due to healthcare costs during the “no-go years.” Overall, the reality is that retirees spend less on an inflation-adjusted basis than the 4% rule would suggest.
The 4% rule also does not account for any one-time withdrawals such as for a big vacation, vehicle purchase, or medical expense. What happens if you need to withdraw 5, 6 or 7% of your portfolio one year for one of these expenses? Can you still go back to withdrawing 4% the next year or do you have to cut back? Again, there's no provisions for real life scenarios like this.
A more realistic approach is to plan for variable spending over time, rather than assuming you’ll need the same amount of money every year. More on that in a minute.
The 4% rule is based on a portfolio consisting of 50% U.S. large-cap stocks and 50% U.S. intermediate-term bonds. While this is a relatively balanced portfolio, it’s far from the most diversified option available.
A well-diversified portfolio should include a mix of U.S. and international stocks, small-cap and mid-cap stocks, real estate, and other asset classes. By diversifying across different sectors and geographies, you can reduce the risk of being overly reliant on any single asset class. In today’s global economy, limiting your portfolio to only U.S. large-cap stocks and bonds might not provide the best long-term growth potential.
While the U.S. stocks have outperformed international stocks over the past decade or more, be conscious of recency bias - the bias that what's happened recently is sure to continue into the future. Retirement can be a 30 year period for most. Over that time, nobody truly knows which sectors will perform best, so investing in all of them to some degree can ensure you take part in the future winners.
This should not be considered personalized investment advice.
The Guardrails Strategy offers a dynamic approach to retirement spending, designed to address the four key flaws in the traditional 4% rule. Unlike the rigid framework of the 4% rule, the Guardrails Strategy allows for more flexibility, taking into account the unique and evolving nature of retirement expenses, portfolio growth, and income needs. Here’s how it tackles each of the major shortcomings in the 4% rule:
1. It Prevents Underspending by Being More Flexible than the 4% Rule
One of the biggest criticisms of the 4% rule is that it tends to be overly conservative, often leaving retirees with more money at the end of their lives than they started with. The Guardrails Strategy addresses this issue by setting parameters that allow retirees to adjust their spending as their portfolio grows or shrinks.
With the Guardrails Strategy, retirees don’t have to stick to a rigid 4% withdrawal rate every year, regardless of how well their investments are performing. Instead, they can increase their spending when their portfolio experiences positive growth, which allows them to enjoy their retirement more. For example, if their portfolio grows by 10%, they can increase their withdrawal rate proportionally, ensuring they don’t die with a massive pile of unspent cash. On the flip side, if their portfolio declines, the strategy prompts them to reduce spending, keeping the portfolio sustainable. This flexibility helps ensure that retirees neither overspend and risk running out of money nor underspend and miss out on the lifestyle they could have enjoyed.
It's important to note a few things about the above example:
You'll notice the lower guardrail (red) is much farther away from the current balance than the upper guardrail (green), meaning the portfolio would have to decline by a significant amount to warrant any income decrease - limiting the possibility of a pay cut in retirement.
The decrease in spending is also minimal compared to the potential increase should the balance hit the upper guardrail. The idea here is that markets have always recovered, so a small (and usually temporary) decrease in spending can go a long way to decrease your odds of running out of money.
It should also be noted that the guardrails are not static, they will change each time one is "hit". For example, if the portfolio increases to $1.2 million, new guardrails will be calculated to project when spending can be or needs to be adjusted once again.
In contrast to the 4% rule, which is based on a worst-case scenario analysis of historical market performance, the Guardrails Strategy adapts to the actual performance of the retiree’s investments. This approach minimizes the risk of leaving too much money on the table, which the 4% rule often results in, as seen in historical back tests that show hypothetical retirees ending with significantly more than they began with.
2. It Accounts for Tax Diversity and Better Utilization of Different Account Types
The 4% rule assumes all retirement savings are in pre-tax accounts, like 401(k)s and traditional IRAs, and doesn’t account for the impact of taxes on withdrawals. This is unrealistic for most retirees, who typically have savings spread across various account types—pre-tax, Roth, and taxable brokerage accounts. Taxes play a major role in how much you can actually spend in retirement, and the 4% rule doesn’t address this.
The Guardrails Strategy, on the other hand, takes into account the diverse types of accounts retirees have. By drawing from different accounts—such as tapping into Roth IRAs for tax-free income or using long-term capital gains rates from a taxable brokerage account—retirees can better manage their overall tax liability. This provides greater spending flexibility and allows retirees to maximize their income based on their tax situation.
Additionally, it allows for more tax-efficient withdrawal strategies by incorporating a mix of Roth conversions and taxable income management. By planning for taxes throughout retirement, retirees can avoid overpaying and keep more of their savings to spend.
3. It Accommodates the Retirement Spending Smile
A major flaw of the 4% rule is that it assumes a flat, inflation-adjusted spending pattern throughout retirement. In reality, most retirees’ spending decreases in the middle years of retirement—the so-called “slow-go years”—and may increase again toward the end due to healthcare costs.
The Guardrails Strategy takes into account this “retirement spending smile,” adjusting withdrawals based on actual spending patterns rather than assuming a steady rate. During the early "go-go years" of retirement, when retirees are often more active and tend to spend more on travel and leisure, the Guardrails Strategy allows for higher withdrawals. As retirees age and their lifestyle slows down, spending naturally declines, which means they can reduce their withdrawals. Finally, in the "no-go years," when healthcare costs often spike, the strategy helps ensure there’s still enough money available by having already factored in the lower spending years earlier in retirement.
This personalized approach provides a more realistic and customized plan for retirees, allowing them to adjust their spending based on actual needs rather than relying on a cookie-cutter rule.
4. It Is Not Tied to a 50/50 Portfolio, Allowing for Greater Diversification
Another flaw of the 4% rule is that it assumes a portfolio invested 50% in U.S. large-cap stocks and 50% in intermediate-term U.S. Treasury bonds. This allocation may not be suitable for everyone, as it lacks global diversification and may not align with individual risk tolerance or investment preferences.
The Guardrails Strategy, by contrast, is not based on a specific asset allocation. Retirees can tailor their portfolio to fit their individual needs, whether that means diversifying across different sectors, countries, or asset classes. It allows retirees to allocate a portion of their assets to less risky investments like bonds and cash, while keeping the rest in stocks for long-term growth. The strategy even provides a buffer, suggesting that retirees keep a certain number of years’ worth of living expenses in lower-risk investments like bonds or cash, to cover their needs during market downturns without having to sell stocks at a loss.
This diversified approach reduces the risk of relying solely on U.S. large-cap stocks and intermediate-term bonds and helps create a more resilient portfolio that can better withstand market fluctuations. It also aligns more closely with modern portfolio theory, which emphasizes the importance of diversification in reducing risk.
A Personalized and Adaptive Approach
Ultimately, the Guardrails Strategy offers a more personalized and adaptive approach to retirement spending. It’s designed to prevent retirees from either running out of money too soon or leaving behind more than they intended, while adjusting for real-life variables like market performance, taxes, and changing spending needs over time. By moving away from the rigid 4% rule, retirees can make the most of their retirement savings and enjoy a more confident, flexible lifestyle.
The 4% rule can be a helpful guideline, but it’s important to recognize its limitations. It’s often too conservative, doesn’t account for taxes or spending variability, and assumes a one-size-fits-all investment approach. By using a more dynamic strategy like the guardrails approach, you can enjoy a retirement that’s better aligned with your actual spending needs and lifestyle.
If you’re interested in learning more about how the guardrails strategy could work for you, schedule a free introductory call. We’d be happy to help you create a retirement income plan that lets you spend confidently, without worrying about outliving your savings.
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This content is educational and not tax, legal, or investment advice. Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful.
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